The Stock Market Who Cried Wolf

A brief history of alarmist—and wrong—Wall Street predictions about the effect of new regulations.

Last week, the Senate agriculture committee, led by Blanche Lambert Lincoln, sent to the floor a bill that would significantly alter derivatives trading. Should it become law—here are the highlights—the bill would require regulated banks with derivatives-trading units to spin them off. It would also require that derivatives, many of which are traded over-the-counter (i.e., not on an exchange), be traded through a central clearinghouse, with pricing and volume data made available to the public.

Predictably, the industry is opposed to the mandates for greater transparency. As Reuters reported, "Exchange trading has nothing to do with reducing credit risk," said Conrad Voldstad, chief executive officer of the International Swaps and Derivatives Association. "In fact, mandating that all swaps be exchange-traded will increase costs and risks for the manufacturers, technology firms, retailers, energy producers, utilities, service companies and others who use over-the-counter derivatives."

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My general rule of thumb is that we should generally ignore what Wall Street has to say about financial regulation. Investment banks lack the common sense to know what's good for them. The financial sector opposed all the regulations that were good for it in the 1930s—i.e. the advent of the Securities and Exchange Commission and the creation of the Federal Deposit Insurance Corp. And the regulatory changes it requested and received in the past decade—eroding Glass-Steagall, getting the SEC to permit investment banks to increase their use of leverage—set the stage for the debacle of 2008.

For the past several decades, Wall Street has continually told Washington that if the Street can't do things the way it always has, and if the government changes the rules to mandate greater transparency and customer protection, that the geniuses in Lower Manhattan won't be able to make money, and it would stunt the industry. They've been wrong every time.

Through the 1970s, NYSE rules required that member firms charge the same fee to execute trades. There wasn't much competition, and there weren't any discounters. On May 1, 1975, over the howls of Wall Street firms, the SEC did away with fixed commissions. (Read more about the process here and here.) As the SEC chairman said at the time: "For the first time in almost 200 years, the rates of commission that brokers charge to public customers … will not be determined by exchange rules. Market forces will operate to set these prices and there may be variances from firm to firm." And, of course, that's what happened. Yes, the incumbent firms found their profits from executing trades were pinched. But the new discounters that formed brought in millions of new investors—who eagerly snapped up the mutual funds and stock offerings of the big Wall Street firms.

In the 1990s, SEC Chairman Arthur Levitt took aim at the archaic method of pricing stocks. Since the 19th century, stocks were priced—and moved—in increments of 1/8. If you were willing to buy IBM at 58 5/8, the market maker (one of those guys on the floor in the funny jackets) would buy it for 58 3/8, give it to you at the higher price, and pocket the difference. By the late 1990s, most stock markets had gone digital, and decimalization—stocks priced and moving in increments of a penny—was becoming the standard. "Currently, the United States securities markets are the only major markets not to price stocks in decimals," Levitt said. "And the overall benefits of decimal pricing are likely to be significant. Investors may benefit from lower transaction costs due to narrower spreads." Over the wails of Wall Street firms, the SEC ordered exchanges to switch to decimalization in 2000 and 2001. If the stock was trading at 50.375, you could offer to pay 50.425. The result: The profits of the market-makers were obliterated, but customers got better treatment. As this 2003 paper suggests: "Quoted spreads decreased substantially after decimalization, on both markets, and for stocks in all market capitalization groups."

Next, the SEC turned its attention to corporate bond trading—a market much less liquid and transparent than the stock market. With many trades conducted over-the-counter, it was difficult for investors to see the best prices and to see what prices other investors had been paying for identical or similar bonds. In 1998, the SEC began to instruct the National Association of Securities Dealers to set up TRACE, a system through which corporate bond trades would be reported in real time. (Here's some history on the process.) Again, bond dealers were less than thrilled. But since TRACE went into action, costs for investors have come down. A paperthat studied trading before and after TRACE found "a reduction of approximately 50 percent in trade execution costs for bonds eligible for TRACE transaction reporting." And the market grew. The TRACE fact book (see Pages 27 and 28) shows the volume and value of bonds traded on the system have increased substantially.

Now the same dynamic is playing out with derivatives. Under the current system—as was the case with stocks and corporate bonds—the large investment banks serve as market makers and keep pricing information close to the vest. They extract fat spreads for doing customers the service of introducing buyers to sellers. But in a range of markets—stocks, antiques, baseball tickets—it has become clear that electronic selling platforms in which buyers and sellers can meet on their own terms are more efficient. That would probably be the case with derivatives as well.

Trading is always a zero-sum game. And in this arena, a gain for customers would be a loss to the Wall Street intermediaries. JPMorgan Chase CEO Jamie Dimon acknowledged as much when he told analysts that if derivatives trading went through clearinghouses it could cost his bank from "$700 million to a couple billion dollars."

Rather than let buyers and sellers meet in exchanges, rather than let investors be able to see the full array of trading in real time, the Wall Street firms effectively want things to work the way they did in the last century, when you had to pick up a phone and call somebody to get a price and execute a trade. The opposition to moving derivative trades to a clearinghouse isn't about protecting customers. It's about protecting the entrenched positions and profits of large banks.

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